Taxes on Inheritance
There is often an assumption that you pay taxes at death and/or when you receive an inheritance. In reality, most people don’t pay death or inheritance taxes, however, this doesn’t mean there won’t be taxes on some assets. What do I mean? I’ll start out with some definitions and then describe tax treatment and considerations for various assets.
Estate Tax – These are taxes due on the estate of someone who passes away. Most states, including California, don’t have an estate tax. The federal estate tax exemption for 2023 is $12.92 million, or $25.84 million for a married couple, which means you won’t owe federal estate taxes unless the value of your estate is above that amount. If your net worth is above that amount, doing some advanced estate planning may be well worth it.
Inheritance Tax – Inheritance tax is a state tax that is paid when you receive money from the estate of someone who has passed away. Again, California doesn’t have this tax, but six states do and those include Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
To summarize the information above, most people don’t pay estate or inheritance taxes. That said, various assets do receive different tax treatments after they are inherited, and those considerations can be very important in financial planning. One of the best tools to use for inheritance and estate planning is to review the titling and beneficiary elections for your assets.
Below is a summary of tax information and some considerations for various types of assets. These are general rules and there can be unique situations that apply depending on when someone passed away (laws have changed over the years with some laws still grandfathered) or in special circumstances such as disabled beneficiaries, etc.
Cash and non-retirement accounts: When you inherit cash or investments the value of those investments at the date of death becomes the new cost basis. This means that any gains that may have existed in the account before death no longer apply from a tax perspective, and the tax basis steps up to the current value. For instance, if a stock was purchased for $10/share and is now worth $30/share, the gain of $20/share would have been realized if sold prior to death, however, once the owner passes the beneficiary inherits the asset with a stepped-up basis of $30 and therefore only gains moving forward are subject to taxes.
Retirement Accounts: Retirement accounts and the investments held inside of them are treated very differently than in the scenario above. Most retirement accounts such as 401k’s and IRA’s (Individual Retirement Accounts) hold pre-tax dollars, meaning taxes have never been paid on these assets. When and if the owner takes distributions from these accounts is when taxes are owed. The same situation exists after inheritance, the new owner will have to pay taxes at their own tax rates when they take money out of these accounts. For example, if you inherit an IRA worth $100,000 and take $10,000 out of the account, you will pay taxes on that $10,000 at your tax rate in the year you take the distribution. Distribution laws have changed in recent years and in most cases, you have to distribute all funds from retirement accounts within 10 years of inheritance, unless you are a surviving spouse and in that case, the 10-year rule doesn’t apply. Planning opportunities exist to determine when and how much to take to minimize taxes on distributions, as well as considerations of leaving these assets to non-profit organizations if the owner has charitable intentions, as those organizations can sell these assets tax-free since they are exempt.
Roth IRA’s: A Roth Individual Retirement Account or Roth 401k works differently again than a Traditional IRA or 401k as these accounts were funded using after-tax dollars. Generally speaking, the accounts are tax-free when distributed as long as the account has been opened for five years, otherwise, earnings withdrawn are subject to income taxes. As with Traditional IRAs, you have 10 years to withdraw all the funds from the account unless you are a spouse.
Inheriting a Home: When you inherit a home it is similar to the information listed for non-retirement accounts, the property receives a step-up in cost basis. For example, if the owner had paid $200,000 for a home and it’s now worth $800,000, you won’t pay capital gains tax on the difference and the new cost basis is $800,000, so if you sell it for that amount you won’t have a taxable gain. Keep in mind that with a home there are other considerations such as continuing to make payments on the mortgage, property taxes, and insurance. State laws vary regarding property taxes. In CA, if you decide you’d like to live in the home as your primary residence then you can keep the same property tax base (up to $1,000,000 above the owner’s assessed value), however, if you decide to keep it for any other purpose such as to rent it out, the home will be re-assessed and your property taxes will adjust.
Annuities: Taxation on annuities can be somewhat complicated and depend on the type of annuity that is owned. If the annuity was a “non-retirement” annuity, then any earnings in the annuity are taxable. If the annuity was part of a retirement plan such as an IRA, then it is taxed as ordinary income as you take distributions. The distribution rules and options are often determined by the annuity company and therefore be sure to speak with them to understand what options are available.
Life Insurance: Life insurance is not generally taxable unless it is part of a large estate or potentially in a state with estate or inheritance taxes.
Keep in mind that this information is not tax or legal advice and I recommend working with an attorney and/or accountant in coordination with a financial planner to make sure you have a well-designed estate plan that fits your situation. A comprehensive estate plan will provide guidance on titling assets and beneficiary designations, and also include wills, powers of attorney, and a trust in most cases.
If you would have questions related to your inheritance planning, feel free to email me at advisor@blakegallion.com
